Making the Most of Year-End Physical Inventory Counts

For retailers, manufacturers and many other businesses, a significant amount of working capital is tied up in inventory. But how accurate is the amount reported on the balance sheet? To best answer that question, a physical count of raw materials, work-in-progress and finished goods is essential at year end. For calendar-year entities, your year end is fast approaching on December 31.

Unfortunately, inventory counts are among the most dreaded chores for business owners and managers. Although these procedures may be seen as time consuming and disruptive, a well-executed inventory count can provide valuable insight into improving operational efficiency. Here’s how to run your count to maximize the benefits and minimize the hassle.

Reviewing the Basics

Inventory includes raw materials, work-in-progress and finished goods. Your physical inventory count also may include parts and supplies inventory. Under U.S. Generally Accepted Accounting Principles (GAAP), inventory is recorded at the lower of cost or market value. Estimating the value of inventory may involve subjective judgment calls, especially if your company converts the goods from raw materials into finished goods available for sale. The value of work-in-progress inventory can be especially hard to objectively assess, because it includes overhead allocations and, in some cases, may require percentage of completion assessments.

A physical inventory count gives a snapshot of how much inventory your company has on hand at year end. For example, a manufacturing plant might need to count what’s on its warehouse shelves, on the shop floor and shipping dock, on consignment, at the repair shop, at remote or public warehouses, and in transit from suppliers and between company locations.

The value of inventory is always in flux, as work is performed and items are delivered or shipped. To capture a static value at year end, it’s essential that business operations “freeze” while the count takes place. Usually, it makes sense to count inventory during off-hours to minimize the disruption to business operations. For larger organizations with multiple locations, it may not be possible to count everything at once. So, larger companies often break down their counts by physical location.

Advance planning is the key to minimizing disruptions. Before the counting starts, management generally should:

Order (or create) prenumbered inventory tags. Most companies use two-part tags to count inventory. One tag stays with the item on the shelf; the other is returned to the manager at the end of the count. Tags are numbered sequentially to ensure the manager can account for every tag issued. Using a tagging system prevents items from being counted twice or omitted. Each tag should identify the part number, location, quantity and person who performed the count.

Preview inventory. Most companies do a dry run a few days before the count to identify any potential roadblocks and determine how many workers to schedule. This makes the count more efficient and gives warehouse personnel the opportunity to correct any foreseeable problems, such as missing part numbers and unbagged supplies.

Assign workers to count inventory. Assemble two-person teams to prevent fraudulent counts. Assign each team a specific area of the warehouse to count. (A map often helps workers identify count zones.) Never give employees inventory listings to reference during the count — otherwise, they may be tempted to duplicate the amount from the listing, rather than bring attention to a possible discrepancy.

Write off any unsalable items. All defective or obsolete items should be thrown away or recycled before the inventory count begins. There’s no sense counting items that will be written off.

Precount and bag slow-moving items. To make the physical count faster, some items that aren’t expected to be used before year end can be counted a few days in advance. Precounted items should be tagged and placed in sealed containers. If a broken seal is noticed on the day of the actual physical count, the items in the container should be recounted.

If your company issues audited financial statements, one or more members of your external audit team will be present during your physical inventory count. They aren’t there to help you count inventory. Instead, they’ll observe the procedures (including any statistical sampling methods), review written inventory processes, evaluate internal controls over inventory, and perform independent counts to compare to your inventory listing and counts made by your employees.

They’ll also look for obsolete, broken or slow-moving items that need to be written off the books. Be ready to provide them with invoices and shipping/receiving reports. Auditors review these documents to evaluate cutoff procedures for year-end deliveries and confirm the values reported on your inventory listing.

Understanding the Importance of Accuracy

It’s important to get the inventory count right for many reasons. First, you want a reliable estimate of ending inventory so that the profits you record this year are accurate. Your cost of sales — a major expense on the income statement — is a function of the value of beginning and ending inventories.

At the most basic level, here’s how the accounting department estimates cost of sales:

Cost of sales = Beginning Inventory + Purchases – Ending Inventory

If the inventory balance is incorrect at the beginning or end of the year, management won’t know how profitable the company truly is.

In addition, inventory is a major line item on your company’s balance sheet. Lenders rely on inventory as a form of loan collateral. Stockholders look to inventory-based ratios (such as the current ratio or days-in-inventory ratio) to evaluate financial strength. And if disaster strikes, your insurance coverage (which is based on asset values on your balance sheet) should be adequate to cover any inventory losses.

Most companies track the value of inventory through a computerized perpetual inventory system; the value increases when purchases are made (or as raw materials are processed into finished goods) and decreases when goods are sold. But a count taken from a perpetual inventory system may not always be accurate.

Explaining Discrepancies

At the end of your physical inventory count, note and explain any discrepancies. Possible reasons for differences between the perpetual inventory system and the physical count include:

Data entry errors

Inaccurate bin or part numbers

Shipping errors

Inventory in the authorized possession of employees (such as owners or salespeople)

Well-executed physical inventory counts have benefits beyond accounting compliance and fraud prevention. They provide opportunities for management to evaluate how to stock items more efficiently, reduce carrying costs and identify actual fraud losses. In turn, more efficient inventory management can lead to improved customer satisfaction and higher sales.

For example, when conducting counts, management should evaluate how the warehouse is laid out. The most commonly used items should also be the most accessible. Employees should navigate the warehouse with familiarity and find items off the inventory listing with ease. Bin and aisle labels should be easy to read quickly. High value items should be locked away during off hours — and counted on a regular basis to reduce pilferage. And plant managers should know how to systematically compute the optimal reorder point and buffer stock levels for key inventory items (rather than just rely on gut instinct) to avoid manufacturing and shipping delays.

Seeking External Input

When it comes to physical inventory counts, accountants have seen the best (and worst) practices over the years. And they can advise you on how to more efficiently manage your inventory. For more information on how to perform an effective inventory count, contact your financial adviser before year end.

Simplified Inventory Reporting Guidelines

In July 2015, the Financial Accounting Standards Board (FASB) issued updated guidance that requires businesses that use the first-in, first-out (FIFO) or average cost method to measure inventory at the lower of cost or net realizable value (NRV), instead of at the lower of cost or market value (Accounting Standards Update (ASU) No. 2015-11,Inventory (Topic 330): Simplifying the Measurement of Inventory).

The FASB defines NRV as “the estimated selling price in the normal course of business, minus the cost of completion, disposal, and transportation.” Businesses that use FIFO or the average cost method will no longer consider replacement cost or net realizable value less a normal profit margin when measuring inventory. Inventory reporting guidelines remain unchanged for companies that use the last-in, first out (LIFO) or the retail inventory method.

The new rule goes into effect for fiscal years that begin after December 15, 2016. Public companies will begin applying the changes to quarterly reports in 2017. Private companies and other organizations will begin applying them to quarterly and other reports covering less than a year in 2018. Early implementation is permitted, but contact your accountant for more details before implementing this change.